A real options game of alliance timing decisions in biopharmaceutical research and development

In this article we examine the alliance timing trade-off facing both pharmaceutical and biotech firms in a stochastic and competitive environment. Specifically, we introduce a real options game (ROG), where a pharmaceutical company can choose between two competing biotech firms by sequentially offering a licensing deal early or late in the new drug development process. We find that, when the alliance raises the drug market value significantly, the agreement is signed late in the drug development process. This suggests that the postponement effect implied by the use of real options prevails over the biotech firms' competition effect, which would instead play in favor of an early agreement for pre-emption reasons. When the alliance does not raise the drug market value significantly, the optimal timing depends on the level of royalties retained by the pharmaceutical company. In particular, an early agreement is signed in the presence of a low level of royalties. In this case, indeed, the competition effect becomes predominant because the pharmaceutical company can substantially reduce the upfront payment and thus the potential loss incurred if the biotech partner does not exercise her option to continue the new drug development process. We also show that the alliance timing outcomes of our real options game considerably differ from those obtained when both parties use the net present value (NPV) to assess their payoffs.